Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

Abstract
Fiscal federalism is concerned with the division of policy responsibilities among different levels of government
and with the fiscal interactions among these governments. Public service provision by lower-level governments
can be efficiency-enhancing, although competition for mobile resources can also interfere with efficient
resource allocation both in the public and private sectors. Intergovernmental transfers affect the overall equity
and efficiency properties of public policies. Global economic integration and political and economic reforms
in developing and transition economies – which have institutional contexts very different from those of the
mature federations – present important challenges for a ‘second generation’ of federalism research.

Keywords
Decentralization; Factor mobility; Fiscal competition; Fiscal federalism; Horizontal equity; Intergovernmental
grants; Local public goods; Optimal currency areas; Planning; Policy coor-
dination; Stabilization policy; Tax competition; Tax distortions; Tiebout hypothesis

JEL Classifications
Fiscal federalism is concerned with the division of policy responsibilities among different levels of
government and with the fiscal interactions among these governments.

The Institutional Context of Fiscal Federalism

Fiscal federalism has long been a topic of keen interest in the United States and Canada. In both
nations, subnational governments have traditionally played major roles in the provision of important public
services, notably in the areas of education, health, social services, transportation, public safety, and economic
development. In addition to non-tax revenues, subnational governments in both countries have had significant
sources of tax revenues, with state/provincial governments relying heavily on retail sales taxes and taxes on
personal and business income and with local governments depending on property taxes. Higher-level
governments (national in relation to subnational, and state/provincial in relation to local) have supported the
finances of lower-level governments with extensive programmes of intergovernmental fiscal transfers in order
to promote the provision of particular public goods and services, to supplement (or perhaps displace) lower-
level government taxes, and to advance broad social welfare objectives. Although they are subject to
constitutional, statutory, and regulatory constraints, state/provincial and local governments exercise substantial
fiscal autonomy with respect to expenditures, taxation and borrowing. National and subnational fiscal policies
have been developed and implemented within the context of continuously evolving but fundamentally durable
market, political, and legal institutions, underpinned by stable democratic constitutional structures.
There are long-established federations (and long traditions of scholarly research on federalism) in other
parts of the world as well, but interest in fiscal federalism has become particularly intense in developing and
transition economies since the early 1990s, no doubt in part because of broad reform initiatives that have
 Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

reduced the role of the state in economic planning and control (Wildasin 1997a, ch. 2). In many of these
countries, constitutional, economic, and political
reforms have led to significant decentralization of tax, expenditure, and borrowing responsibilities, often
accompanied by the development of new systems of intergovernmental fiscal transfers.
In contrast to the mature North American federations, the newly (or increasingly) decentralized and
liberalized economic and fiscal systems of many developing and transition economies are being implemented
in the absence of the background political, legal, and market institutions found in more developed nations. The
development and restructuring of federations around the world has presented many practical challenges and,
for scholars, important questions regarding the design of federal systems, the implementation of fiscal reforms
in such systems, and the interactions between basic social institutions and the public sector in federations.

Fiscal federalism is also a subject of increased interest and concern in the European Union.

Fiscal decentralization has accompanied economic and political reforms in several European nations. In
addition, the interactions of tax, expenditure, debt, and monetary policies among EU member states
continuously raise questions concerning international policy coordination and the development of EU-wide
supranational institutions. Controversy surrounds the issues of national sovereignty and the upward transfer of
powers from national governments to EU executive, legislative, and judicial bodies. In important respects,
however, the EU can be viewed as an emerging federation in which EU-level political and fiscal institutions
are gradually developing within the context of an increasingly integrated and expanding system of developed
and transition economies. From this perspective, the EU itself is a (so far relatively limited) higher-level
government in relation to the national governments of its member states.
Fiscal federalism is thus a subject of great interest throughout the world. Wide international variation
in the institutional context of federalism has stimulated what Oates (2005) calls a ‘second generation’ of fiscal
federalism research, differentiated from ‘first-generation’ research by its heightened attention to political,
constitutional, financial and macroeconomic institutions. For example, issues of fiscal discipline, soft budget
constraints, and subnational government borrowing, little discussed within the context of traditional federalism
research, have received considerable attention in recent years (Inman 2003; Wildasin 1997b, 2004), especially
with reference to newly decentralizing fiscal systems. Because the policy issues and institutional context of
federalism varies widely throughout the world, a rapidly growing literature deals with fiscal federalism in an
international context, often focusing on unique policy issues facing individual countries (see, for example, Bird
and Vaillancourt 1998; Martinez-Vasquez and Alm 2003; and Rodden et al. 2003, which contain many studies
of federalism problems in developing and transition economies).
As the foregoing remarks suggest, problems of fiscal federalism touch upon almost all aspects of fiscal
policy, in almost all nations (especially the large nations and economic regions) of the world.
 Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

The subject is correspondingly very broad. The following paragraphs highlight recurring themes that
have occupied researchers for many years as well as selected issues that are likely to be the subject of active
inquiry in coming years. The discussion begins with fundamental issues regarding the economic functions of
different levels of government, noting their implications for the
organization of the public sector. The potential efficiency gains from decentralized policymaking
as well as the limitations of decentralization are discussed next, emphasizing the importance of
resource mobility and fiscal competition as a crucial feature of the decision-making environment
facing lower-level governments. Finally, directions for new research are briefly discussed.

The Organization of the Public Sector

What economic functions can, do, or should be performed by different levels of government? This
fundamental question has been a focus of the federalism literature from its inception. There has been a broad
normative consensus (Oates 1972) that, of Musgrave’s (1959) ‘three branches of the public household’, the
highest-level government (normally a national government, but possibly a supranational entity like the EU)
should take responsibility for stabilization functions (that is, macroeconomic and monetary policies), that
allocative functions (the provision of public goods and services and correction of market failures) should be
undertaken by governments whose jurisdictional boundaries are coterminous with the geographical scope of
the regions affected by these policies, and that higher-level governments should be responsible for policies that
target the distribution of income. Subnational economies are comparatively more open than national
economies, which means that the impacts of stabilization policies are diluted through capital, labour, and
financial flows when undertaken by lower-level governments; see, for example,
Mundell’s (1961) classic work on optimal currency areas. Similarly, the mobility of labour and capital
constrains the ability of (small, open) subnational governments to alter the net distribution of income. For
example, high taxes on the rich in one jurisdiction create incentives for the rich to locate elsewhere, while the
provision of generous cash or in-kind benefits for the poor attracts beneficiaries (Stigler 1957). In addition to
distorting the efficiency of resource allocation, the spatial
reallocation of resources in response to local re-distributive policies limits the set of feasible
policies as well as their impact on net incomes.
Lower-level governments may, however, serve effectively to provide public goods and services in the
amounts that are most efficiently adapted to local benefits and costs, which normally vary among locations in
accordance with differences in demographic composition, incomes, and technologies (Oates’s
‘decentralization theorem’).

Allocative Efficiency at the Local Level

The decentralization theorem shows that nonuniform provision of public goods, varying in
accordance with local benefits and costs, may be more efficient than uniform provision. In princi-
 Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

ple, however, an omniscient and omnipotent central planner could implement optimal nonuniform policies,
obviating the need for distinct administrative units of lower-level government. Such a planner could manage
all public sector functions (in fact, all economic decisions) for the entire world. A key idea in the literature of
fiscal federalism, however, is that lower-level units of government may be better informed about and more
responsive to local demands. The information needed for efficient decision-making, and the incentives to use
this information, may differ by level of government, just as markets provide incentives guiding decentralized
market decisions for households and firms in ways not achievable, in practice, by central planning mechanisms.
This idea is developed explicitly, if informally, in Tiebout (1956). Tiebout draws the analogy
between consumers shopping for commodities in the marketplace and households choosing resi-
dences from among a collection of localities. Writing soon after and in response to Samuelson’s
classic contributions to public goods theory, Tiebout asserts that households reveal their preferences for local
public goods when they choose where to reside. Different localities provide different levels of public services,
as illustrated by local school districts in the United States that offer different qualities of elementary and
secondary education. Households with high valuations for education can outbid others for residences in
localities with good schools, thus leading to a sorting of households by demand for public services. According
to Tiebout, this matching of demand and supply leads to efficient provision of local public goods.
Tiebout’s paper identifies local governments as distinct economic units that can perform important
allocative functions in ways that central governments cannot. Tiebout is not specific, however, about exactly
how local decision-makers determine public goods levels – whether by voting or through some other
mechanism. Many subsequent contributions (see, for example, Wildasin 1986, for a survey and references),
including both theoretical and empirical analyses, explore in detail the phenomenon of ‘Tiebout sorting’ and
the implications of community stratification, by income, race, religion, age and other household attributes, for
variation in local public expenditures. Median voter models (and variants thereof) commonly provide a
theoretical starting point for empirical analyses of the demand for local public goods. Linkages between
housing markets and local fiscal policies, as revealed by hedonic price relationships, suggest that local voters
have incentives to support policies that preserve property values. In the extreme, these linkages may obviate
altogether the need for households to participate in the collective decision-making process, by providing profit-
maximizing property developers and other market participants with the information and incentives to make
efficient policy choices, resulting in completely market-driven provision of public goods (Fischel 2001,
discusses land use regulation, property development and their interactions with community formation and local
policymaking).
In addition to the information and incentives that may result from the mobility of households
and firms, emphasized by Tiebout, decentralized policymaking may also provide a framework for
experimentation and learning about policy alternatives and their consequences as well as for learning about
the performance of policymakers themselves (Besley and Case 1995).
 Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

Limits to Decentralization: Efficiency and Distributional Considerations

Tiebout’s analysis and much subsequent research highlights the potential benefits, especially with
respect to the efficiency of public good provision, from competition among lower-level governments for
mobile households and firms. The potential disadvantages of fiscal decentralization have long been recognized,
however. For instance, the economic service areas for local public goods may not closely match jurisdictional
boundaries. Local health, educational, or transportation policies may benefit residents of neighbouring
localities or society at large, spillover benefits that local decision-makers may ignore. These externalities can
potentially be internalized through voluntary policy coordination among neighbouring governments. Such
coordination can be costly, however, resulting in inefficient decentralized public good provision.
Within a federation, a higher-level government can use intergovernmental grants (generally
conditional grants, especially matching grants that reduce the marginal cost of public good provision for
recipient governments) in order to induce more efficient provision of externality-generating local public goods
and services (Breton 1965). If the spillover benefits from a public good are sufficiently widespread, a higher-
level government may assume complete responsibility for its provision. Such centralization of a governmental
function involves a trade-off between the potential benefits from internalization of externalities and the
potential informational disadvantages of centralized collective decision-making for a larger and more
heterogeneous population (Alesina and Spolaore 2003).
A second possible drawback of decentralized policy-making arises if there are significant limitations on the
fiscal instruments available to lower-level governments. In the competition among lower-level governments
for households and businesses, taxes (or non-tax revenue instruments such as user fees or licenses) perform a
‘price like’ function by rationing access to public services. Taxes may also introduce inefficiencies of their
own, however, not only through ‘classical’ tax distortions (distortion of in situ labour/leisure, consumption,
savings, and investment decisions) but more especially through their effects on the locational choices of
households and businesses.
For example, subnational government income taxes may inefficiently drive profitable businesses and
high-income households into low-tax jurisdictions, and retail sales taxes may encourage inefficient cross-
boundary shopping. Fiscal competition for mobile factors of production or consumers may discourage taxation
of these resources, changing the composition of the subnational revenue structures toward less-mobile tax
bases if these are available and potentially constraining the overall level of government revenues.
Underprovision of public goods may result, which, as in the case of spillover benefits, may potentially be
remediated with well-designed fiscal transfers from higher-level governments (Wildasin 2006a; Wilson and
Wildasin 2004; Wilson 1999). On the other hand, if Leviathan governments are likely to engage in excessive
spending, fiscal competition may impose useful constraints on their revenue-raising powers (Brennan and
Buchanan 1980).
A further difficulty for federalized systems arises from the fact that many public policies, by
 Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

their nature, intermingle allocative and distributional impacts, so that a clean separation of allocative and
redistributive functions between higher- and lower- level governments may be unattainable. Health, education,
transport, economic development, and many social services involve allocative functions (service delivery for
geographically limited areas) but also promote distributional goals. Particularly when competition among
lower-level governments results in the formation of communities that are relatively homogeneous (with respect
to income, race, age or other socioeconomic characteristics), the efficiency gains from decentralization may
be realized in part precisely through increased disparities in public service provision. The demand for
education, for example, is a normal good, so that stratification of localities by income produces disparities in
educational quality between rich and poor localities, as efficiency requires. In the United States, concern about
the fairness of inequality in education, partly as expressed in state government constitutions, has resulted in
extensive litigation leading to judicial mandates for policy reforms, notably including extensive programmes
of equalizing fiscal transfers from state to local governments (Inman and Rubinfeld 1979). More generally, the
equalization of fiscal transfers from higher- to lower-level governments provides a mechanism through which
to limit horizontal inequities in the fiscal treatment of households in rich and poor jurisdictions and the
locational incentives to which they give rise (Boadway and Flatters 1983).
As noted earlier, factor mobility imposes constraints on the ability of governments to redistribute
incomes. The integration of capital and labour markets can improve the efficiency of factor allocations and
thus raise output and welfare, an important potential benefit that underpins policy initiatives, such as economic
integration within the EU, that seek to remove barriers to factor
mobility. Factor mobility also affects factor prices, giving rise to potentially important first-order distributional
impacts. Thus, economic integration affects not only the cost of ‘decentralized’ redistribution – which, in a
global context with international factor mobility, includes redistribution by national as well as subnational
governments. By affecting factor prices and the underlying distribution of income, it also may increase or
decrease the benefits of re-distributive policies. International capital mobility and the migration of younger
workers (both skilled and unskilled) from developing and transition economies to aging developed nations
thus create new policy trade-offs, particularly for the extensive re-distributive systems of North America and
Western Europe (Wildasin 2006b), the consequences of which will unfold in coming decades.

Directions for Future Research

As noted at the outset, the challenges of policy and institutional reform throughout the world have
stimulated new interest in fiscal federalism. The incentives embedded in the institutional structures
of the mature federations seem to have ensured that subnational governments maintain sufficient
fiscal discipline to avoid major widespread or recurring fiscal crises, while preserving their abil-
ity to exercise significant policy autonomy with respect to the level and composition of their taxes,
expenditures and debts (Buettner and Wildasin 2006; Inman 2003; Wildasin 2004). Such institutions cannot
be taken for granted, however, and many informed observers see potential risks from fiscal decentralization in
 Eprime Eshag - Federalismo Fiscal (2008) – dicionário Palgrave

the evolving federations of the developing and transition economies, including risks from excessive (that is,
inefficiently high) spending or borrowing by subnational governments. An appropriate mix of revenue and
expenditure assignments, intergovernmental fiscal transfers, borrowing flexibility, and policy autonomy is
needed in order to realize the potential efficiency gains from fiscal decentralization (McLure and Martinez-
Vasquez n.d.; Weingast 2006). The interplay between the market environment (especially financial markets
and institutions and capital and labour mobility), the assignment of fiscal and regulatory authorities by level
of government, and the constraints that influence political decision-making is not well understood and promises
to be the subject of extensive study in coming years.
The integration of national and international markets for labour and capital, of crucial impor-
tance for federalism, appears to be increasing over time, and affects the competitive pressures facing
governments at all levels. The global configuration of age-imbalanced demographic structures (young poor
populations in developing countries and old rich populations in developed countries) implies that international
migration incentives are unlikely to diminish in the foreseeable future. The fiscal systems of developed nations,
with their extensive systems of intra- and inter-generational transfers, will face growing challenges in coming
decades as a result of population aging, even as Fiscal Federalism competition for capital investment and
mobile high-income households may increasing constrain their capacity to finance redistribution (Wildasin
2006c). Policy coordination, perhaps through newly developed governmental structures (for example, at the
EU level), may provide opportunities for national governments to limit the degree of fiscal competition,
helping them to finance the liabilities arising under existing redistributive systems. Alternatively, or in addition,
national governments may explicitly or implicitly shift some expenditure responsibilities to lower-level
governments as they manage growing fiscal imbalances arising from demographic change. In any case,
growing fiscal imbalances are likely to form the backdrop for public finance in developed countries in coming
decades, offering opportunities for fruitful analysis of the dynamics of factor mobility, factor market
integration, dynamic fiscal adjustment, and institutional change within and among nations.

See Also
Intergovernmental Grants
Local Public Finance
Public Finance
Tax Competition
Tiebout Hypothesis

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